It's time to rethink mortgage tax breaks

The Great Recession demolished one myth about owning a house, that values never go down. Now it's time to jettison the one about tax deductions for mortgage interest payments.

It goes something like this: The American Dream itself depends on being able to deduct the interest you pay on your mortgage. Cutting, capping or dropping it altogether will -- take your pick: depress home values; make it harder for minority families to buy a house; lower the overall ownership rate, and destabilize society at large.

While it may be true that owning a home has tremendous social value, there's little proof that being able to deduct the interest payments on a mortgage is essential to fostering an ownership society. In fact, the plethora of tax incentives may have contributed to the financial mess many homeowners currently find themselves in.

In recent weeks, two bipartisan deficit panels have recommended eliminating mortgage interest deductibility or replacing it with a direct credit as part of a broader plan to reduce spending, raise taxes and lower the federal deficit.

These plans, which both include tax simplification and sharp reductions in income tax rates, are a long way from becoming law, but they have initiated much-needed conversations about a variety of sacrosanct special interests and tax incentives.

The chief argument against mortgage interest deductibility is that it is expensive and inefficient. It will cost the U.S. Treasury about $130 billion -- almost three times the annual budget of the Department of Housing and Urban Development -- in 2012 alone. While we're at it, let's tack on another $31 billion for the deductibility of property taxes, and about $50 billion for the exclusion of capital gains on the sale of residential property.

Most of these financial benefits accrue to people in the highest tax brackets -- the people who don't need a subsidy to buy a house in the first place. A 2008 study in one economics journal concludes that households with incomes exceeding $250,000 receive 10 times the tax savings from interest deductibility as households earning between $40,000 and $75,000.

The incentive also distorts choices, encouraging people who receive the smallest benefit to live in a more expensive home. Who hasn't had a real estate agent whisper in their ear that, "the more house you buy, the bigger your tax break"?

Worse, these tax incentives have not led to higher U.S. homeownership rates, which stood at just under 67 percent this past summer. Canada's homeownership rate is 68 percent despite never having allowed interest deductibility. Great Britain eliminated mortgage interest deductibility in 2000, and the homeownership rate climbed. It's about 68 percent.

Mortgage interest deductibility isn't the only proposal in the recent deficit reduction plans, but few have as many advocates. The housing industry represents about 16 percent of the United States' gross domestic product, and loud opposition to the proposal from Democrats, Republicans and industry interests illustrates why it's often called, along with Social Security, "the other third rail of American politics."

The National Association of Realtors weighed in immediately, with economist Lawrence Yun predicting that eliminating the deduction would reduce home values by an additional 15 percent and destroy family wealth.

"Since the inception of the tax code nearly 100 years ago this has been seen as an appropriate social deduction," said Christopher Galler, chief operating officer for the Minnesota Association of Realtors. "Why change the rules on people now?"

But rules change as society does, usually not with the devastating effects that industry groups often predict. Consumers didn't cut up their credit cards in 1986, for example, when the Tax Reform Act ended tax deductions for interest payments on credit card debt.

That legislation for the first time made a special carve-out for mortgage interest deductions. A year later, Congress enriched the benefit by allowing consumers to deduct interest payments on home equity loans. Presto! Interest payments on that LCD television or Mexican vacation became tax-deductible.

This is not the first time someone has suggested eliminating mortgage interest deductibility. The first failed effort was in 1963. Sen. Ted Kennedy tried in 1980, and a budget advisory panel convened by President George W. Bush in 2005 recommended replacing it with a smaller credit. The panel also recommended eliminating the deduction completely for second homes and home equity loans.

"There's a vast and powerful lobby behind that tax deduction, so I have a hard time seeing how it ever passes," said Alex Stenback, a Twin Cities area mortgage banker and author of a closely read industry blog, Behind the Mortgage.

George Karvel, a professor of real estate at the University of St. Thomas, believes that mortgage interest deductibility does provide a valuable incentive toward homeownership, and he cautions against doing anything drastic now, given the fragile state of the housing sector.

"For many people, being able to deduct their mortgage interest might be the only thing keeping their head above water at the moment," Karvel said.

Still, Karvel likes the idea of eliminating the deduction for interest paid on second home mortgages, and interest payments for newly issued home equity mortgages. And he thinks there might be support for limiting the deduction on primary residences to mortgages of $500,000 or less.

He thinks the odds of something happening this time around might be better than ever because of growing awareness of the financial challenges affecting the country's long-term prosperity.

"What is slowly being recognized by the public and politicians alike," Karvel said, "is that our governments have made promises to deliver future benefits, in Social Security, in Medicare, that they will not be able to deliver on unless we start acting now."